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Why it's hard to castrate a bull market

Markets have moved further and further away from simple, accurate methods for valuing stocks, and as traders and regulators have reacted to change, something critical has been lost forever.

In 1906, the great statistician Francis Galton observed a competition to guess the weight of an ox at a country fair. Eight hundred people entered. Galton, being the kind of man he was, ran statistical tests on the numbers. He discovered that the average guess was extremely close to the average weight of the ox. This story was told by James Surowiecki, in his entertaining book The Wisdom of Crowds.

Not many people know the events that followed. A few years later, the scales seemed to become less and less reliable. Repairs would be expensive; but the fair organiser had a brilliant idea. Since attendees were so good at guessing the weight of an ox, it was unnecessary to repair the scales. The organiser would simply ask everyone to guess the weight, and take the average of their estimates.

A new problem emerged, however. Once weight-guessing competitions became the rage, some participants tried to cheat. They even tried to get privileged information from the farmer who had bred the ox. It was feared, however, that if some people had an edge, others would be reluctant to enter the weight-guessing competition. With few entrants, you could not rely on the wisdom of crowds. The process of weight discovery would be damaged.

So strict regulatory rules were introduced. The farmer was asked to prepare three-monthly bulletins on the development of his ox. These bulletins were posted on the door of the market for everyone to read. If the farmer gave his friends any other information about the beast, that information was also to be posted on the market door. Anyone who entered the competition with knowledge about the ox that was not available to the world at large, would be expelled from the market. In this way, the integrity of the weight-guessing process would be maintained.

Professional analysts scrutinised the contents of these regulatory announcements and advised their clients on their implications. They wined and dined farmers; but once the farmers were required to be careful about the information they disclosed these lunches became less useful.

Some brighter analysts realised that understanding the nutrition and health of the ox was not that useful anyway. What now mattered were the bystanders’ guesses. Since the beast was no longer being weighed, the key to success did not lie in correctly assessing its weight, but in correctly assessing what others would guess. Or what other people would guess others would guess. And so on.

Some people, such as old Farmer Buffett, claimed that the results of this process were more and more divorced from the realities of ox-rearing. But he was ignored. True, Farmer Buffett’s beasts did appear healthy and well fed, or his finances ever more prosperous: but he was a countryman who did not really understand how markets work.

International bodies were established to define the rules for assessing the weight of the ox. There were two competing standards – generally accepted ox-weighing principles and international ox-weighing standards. But both agreed on one fundamental principle, which followed from the need to eliminate the role of subjective assessment by any individual. The weight of the ox was officially defined as the average of everyone’s guesses.

One difficulty was that sometimes there were few, or even no, guesses of the weight of the ox. But that problem was soon overcome. Mathematicians from the University of Chicago developed models from which it was possible to estimate what, if there had actually been many guesses as to the weight of the ox, the average of these guesses would have been. No knowledge of animal husbandry was required, only a powerful computer.

By this time, there was a large industry of professional weight guessers, organisers of weight guessing competitions and advisers helping people to refine their guesses. Some people suggested that it might be cheaper to repair the scales, but they were derided: why go back to relying on the judgment of a single auctioneer when you could benefit from the aggregated wisdom of so many clever people?

And then the ox died. Among all this activity, no one had remembered to feed it.

Copyright The Financial Times Limited 2012.

John Kay, Financial Times

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